INSIGHT: Accountant’s Settlement Payment Not Excluded From Gross Income

Sept. 16, 2020, 8:01 AM

Taxpayers not only owed tax after the IRS disallowed the claimed benefits of a tax shelter but also owed tax on the settlement paid by the accountant who set up the tax shelter.

In addition, the taxpayers owed the government its litigation expenses in defending its position on the taxation of the settlement, a federal appeals court recently ruled (McKenny v. United States, No. 18-10810, 2020 BL 332090 (11th Cir. 9/1/20))

Grant Thornton, an accounting firm, recommended that Joseph McKenny structure his consulting business as an S corporation. Grant Thornton also recommended that the S corporation be wholly owned by an ESOP whose sole beneficiary would be none other than McKenny. McKenny also acquired a 25% interest in a GMC car dealership. Based on Grant Thornton’s advice, this 25% stake was formally held in a separate S corporation. This other S corporation was in turn wholly owned by the ESOP.

Pursuant to a 2005 audit, the Internal Revenue Service determined that the Mr. McKenny and his wife had underpaid their taxes. According to the audit, the McKennys’ tax strategy as to the car dealership was an unlawful and abusive tax shelter. The audit also identified unpaid liabilities as to the consulting business.

The McKennys settled their unpaid liabilities with the IRS. They ultimately paid the IRS $2.24 million in income taxes, interest, and penalties. The McKennys sued Grant Thornton in state court. They alleged that the firm committed accounting malpractice and was therefore responsible for their unpaid tax liabilities. In 2009, Grant Thornton settled the suit by paying the McKennys $800,000. In the settlement agreement, however, Grant Thornton expressly denied the claims against it and all liability related to the tax advice it provided to the McKennys.

On their 2009 tax return, the McKennys deducted legal fees they paid to litigate the malpractice claim and excluded the settlement payment from their gross income. The district court concluded that the legal expenses were not deductible business expenses because the McKennys sued Grant Thornton on their own behalf, rather than on behalf of the consulting business. The district court agreed with the McKennys that the settlement was a return of capital and therefore excludible from gross income. Each side, unhappy with only a partial victory, sought complete vindication in the U.S. Court of Appeals for the Eleventh Circuit.

Origin of the Claim

Whether litigation costs are deductible as a business expense depends on whether the litigation is “business or personal.” The question was whether the claim arose “in connection with the taxpayer’s profit-seeking activities.” The determinative factor was “the origin and character of the claim with respect to which an expense was incurred.”

The litigation between the McKennys and Grant Thornton was personal in both its character and origin. The lawsuit concerned the McKennys’ personal tax liability, not the tax liability of any business. The complaint alleged that Grant Thornton breached an agreement with the McKennys, not Mr. McKenny’s businesses; and the complaint alleged malpractice as to services provided to the McKennys, not the businesses. In short, the lawsuit’s essential contention was not that Grant Thornton failed to adequately support the businesses’ income-producing activities, but rather that Grant Thornton failed to help the McKennys reduce their personal tax liability. “We therefore,” the court said, “affirm the district court’s grant of summary judgment to the government as to the litigation expenses.”

Return of Capital

The McKennys relied upon a venerable U.S. Tax Court decision holding that gross income does not include a payment made as compensation for damages that was caused by a third party’s negligence in the preparation of a tax return. See Clark v. Commissioner. The IRS acquiesced in the Clark ruling. See Revenue Ruling 57-47.

The government asserted that Clark was distinguishable. It relied principally on Old Colony Trust Co. v. Commissioner, which holds that a third party’s payment of a taxpayer’s tax liability is generally included in gross income. It also argued that Clark is limited to situations in which an accountant makes a mistake in preparing a tax return or in advising the taxpayer on how to prepare the return. Clark, said the government, “does not apply to settlements based on claims that an accountant committed malpractice in giving advice about, structuring, or implementing a transaction.” (Emphasis added.) In the government’s view, the Grant Thornton settlement involved the latter scenario and was essentially a payment of a portion of their tax liability.

Was Clark correctly decided? If it was, does it apply where, as here, the accountant’s malpractice concerns not the preparation of the taxpayer’s return but rather negligent advice or implementation concerning an underlying transaction?

It was the IRS’s position that an indemnity payment or reimbursement of the taxpayer’s “proper tax liability,” as opposed to a reimbursement of tax liabilities in excess of the taxpayer’s proper tax liability, where such excess is caused by the tax adviser’s negligence, represents a gain that is includible in gross income. See PLR 9743035, July 28, 1997.

We need not, the court said, decide these difficult questions. Assuming that Clark was correctly decided, and that its rationale applies in a case like this one where the accounting malpractice related not to the preparation of a tax return but to the structuring of an underlying transaction, the McKennys did not sustain their burden of demonstrating that the $800,000 settlement was excludible.

In the district court, the government argued that it was entitled to summary judgment because the McKennys could not establish the factual predicate of their argument as to the exclusion of the settlement. The government maintained that their “claimed harm was entirely speculative” and nothing in the record showed that they “would have been entitled to the ESOP or its tax benefits.” The government pointed out that the McKennys “had designated no expert witness who could testify as to the fact that they would have received tax benefits had Grant Thornton performed differently, and offered no admissible evidence or credible means that they could prove that they were uniquely entitled to the benefits of the ESOP tax shelter.”

The district court rejected the government’s argument, explaining that the ESOP strategy was legal at the time Grant Thornton proposed it to the McKennys. The government, the appellate court thought, was correct. The general legality of the S/ESOP strategy at the time was, by itself, insufficient for the McKennys to satisfy their burden. “It is not enough for the McKennys simply to make a bald assertion, devoid of specifics, that they overpaid taxes or would not have incurred any federal taxes (or penalties) had Grant Thornton followed through on the S/ESOP strategy,” (emphasis added) the appeals court said. Furthermore, the S/ESOP strategy was disallowed as of Dec. 31, 2004, and therefore could not have provided the McKennys with any tax benefits (or at least not the same tax benefits) in tax year 2005.

“In short, aside from claiming that the ESOP strategy would have automatically resulted in no taxes in the years at issue, the McKennys did not present any evidence concerning how the strategy would have actually operated on the ground. They did not submit anything” about what tax benefits the strategy would have provided. They did not offer the testimony of a tax expert with regard to how the S/ESOP strategy would have played out had Grant Thornton implemented it, the appeals court said.

The government, therefore, was entitled to summary judgment with regard to the $800,000 Grant Thornton settlement. The appeals court affirmed the district court’s summary judgment in favor of the government as to the litigation expenses. With respect to the $800,000 exclusion, “we reverse the district court’s grant of summary judgment in favor of the McKennys.”

Since the court never reached the question of whether Clark was correctly decided; and/or the nature and type of payments to which the Clark rationale properly applies, the question of whether Clark should be relegated to the historical dust bin will, unfortunately, remain unanswered.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.

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